9/30/2004 @ 10:20AM

Taking Economics At The Electoral College

With the first presidential debate looming this evening and the election itself five weeks off, most polls show President George W. Bush with a five or more percentage point lead.

Other economic-based election predictors are showing even more positive results for the incumbent while at the same time, one investing newsletter is pointing to data which tout the prospects of Sen. John Kerry.

So far this year, two very different economic predicting tools have gotten a great deal of attention, and both are right now pointing strongly to Bush. The first is the model published by Yale economist Ray Fair, which is predicting that Bush will win something like 57% of the popular vote, a much bigger win for the president than any poll ventures.

But what’s rarely mentioned in articles on the Fair model is that it’s really not a predictive tool at all. Fair employs a technique called regression analysis which plots data points along a line. But the accuracy of the Fair model in the past (which is not that impressive on a second look) is based in part on the use of numbers that are not even known until after the election. Second, as noted last month by John Allen Paulos, a Temple University mathematics professor writing for ABCNews.com, the Fair model is based on just 22 data points (6 after the basic model was devised in 1978). That’s much less data than most economists would expect in charting anything else. Paulos called the paucity of data a “glaring weakness.”

Another weakness is that Fair is what Paulos calls “data dredging–after-the-fact torturing of data to reveal accidental relationships and meaningless correlations.” With the world of data at his feet, Fair was free to select variables that “predicted” elections that were long in the past. That doesn’t mean they are likely to predict the future, especially when every election has unique aspects. This year, for instance we have for the first time the war on terror and the Iraq war, which may or may not be the same thing, depending on whom you ask.

A second favored tool is the Iowa Electronic Market. The IEM is a “real” market, where real traders put up real money. The traders win their bets if the candidate whose shares they have purchased winds up in the White House. The IEM has turned strongly pro-Bush (meaning not that the traders want him to win, but that they think he will win).

As of Sept. 28, Bush was trading at 72 cents, compared to 28 cents for Kerry. In late August, both Bush and Kerry shares were trading for around 50 cents, reflecting the traders’ collective view that the election was a tossup.

The Iowa Market is often said to have a strong track record. But that assessment is based on just a few elections–even less than the Ray Fair model. It has not always been more accurate than the polls, and on this date in 2000, it had Al Gore solidly ahead of Bush with his “contracts” trading at 56.6 cents. Gore’s lead grew in early October to the point where his contracts were selling for 63 cents–not quite as high as the Bush shares now, but still well in the lead. Some say the debates turned the tide against the then vice president.

The IEM has been wrong this year, too. On the eve of the Iowa caucuses, former Vermont Gov. Howard Dean contracts were selling for 50 cents and Kerry contracts were just 13 cents. Kerry’s stock shot up immediately after the caucuses, but to just 38 cents, compared to 25 cents for Dean.

Early this week, InvesTech, a Montana-based investment newsletter entered the fray, with a very different prognosis. The authors point out that the last stock market results for the last two months prior to a presidential election have proved to be an uncanny predictor of the vote: “Since 1900, there have been 26 Presidential elections. In 16 of them, the [Dow Jones Industrial Average] climbed during the two months preceding election day. The incumbent President or party won in 15 of those 16 instances. However, in 9 of the 10 elections where the DJIA fell in those two months preceding election, the incumbent party lost.” Meanwhile consumer confidence is down, albeit slightly.

InvesTech concedes the data may be a fluke. More likely investors and the voters were in lockstep because both were indicating either general favor or disfavor about the status quo.

One of the “fluke” years was 1968, where the incumbent Democrats lost despite a 3.1% rise in the Dow leading to the election. That year, there was a controversial war, just as there is this year.

Of course, we do not now know how the market will fare in the last two months leading up to November. So far the Dow is down 1.6% since Sept. 2, which suggests a Kerry victory. The Dow is also down about 5% since Bush took office. The S&P and the Nasdaq have fared worse. On the other hand, all the indices have bounced back since the lows of late 2002. There is still plenty of time for the market to head into the black (especially for just two months prior to the election).

In short, the economics are a muddle. We may just have to allow the voters to decide the election after all.